News on the Greek debt struggle continues to dominate other market news, and just won’t abate. Over the weekend, in its latest move to avoid default and keep Greece in the euro, the Greek Cabinet approved cutting one month’s wages from all elected officials and imposed a levy on property over the next two years. These measures come before the EU, ECB and IMF troika decide whether to forward Greece the next bailout payment. However, eurozone countries are asking Prime Minister George Papandreou to come up with a rescue plan which specifies application, delivery and execution, rather than just fancy talk.

Germany, though, seems to be preparing itself for a Greek default- Vincent Micallef

The bond markets are now pricing in a 98 per cent probability that Greece will default on its debt obligations over the next five years as Mr Papandreou’s government is desperately failing to reassure investors Greece can survive this crisis. It now costs a staggering US$5.8 million upfront and $100,000 per annum to insure $10million of Greek debt over five years using CDS – credit default swaps (should Greece default, the seller will pay the CDS holder CDS 100 per cent of face value). Two-year Greek bonds are now priced to sell at (bid) yields of over 70 per cent, equating to prices in the low 30s.

Naturally this is having an effect on the eurozone market in general: the closer we get to a Greek default the more difficult it would be for peripheral eurozone countries to raise capital. On Tuesday, Italy sold €3.9 billion of their five-year benchmark bond at an average yield of 5.6 per cent compared to 4.93 per cent when it last issued bonds in July this year. 10-year Italy bond yields rose to over six per cent in early August spurring the European Central Bank to shore their price up by buying debt for their books. In the current economic scenario of low growth, issuing debt at rates in excess of six per cent per annum is simply unsustainable.

The euro too has taken a battering, falling from 1.45 against the US Dollar towards the end of August, to 1.367 at the time of writing, in part due to the ECB signalling a shift toward reversing the increases in the zone’s interest rates earlier this year.

French banks, heavily exposed to Greek debt have suffered massive losses in the stock market over the last 10 weeks, dropping on average 50 to 60 per cent over the period. Credit rating agency Moody’s placed the ratings of Societe Generale, Credit Agricole and BNP Paribas on review for a downgrade as early as this quarter citing “the potential for inconsistency between the impact of a possible Greek default or restructuring and current rating levels.”

One of the conditions which the ECB and IMF imposed on Greece in return for bailout funds is the involvement of the private sector (PSI), including financial institutions, insurers and all other non-sovereign bodies and agencies. In this PSI deal, Greece will be asking investors holding bonds maturing till 2020 to express their interest to (voluntarily) participate in a bond exchange programme which Greece will be hoping to implement by mid-October this year, through one of four options. In every case, investors will take losses of 21 per cent of their Greek sovereign debt.

In two of the options, current bonds are given in exchange new 30-year notional par bonds with low coupons which increase over the first 10 years. Investor capital is fully protected, hence should Greece default on this structure, bondholders are assured of their capital (at maturity).

In a third option, holders would in exchange receive 80 per cent of their holding in 30-year “discount bonds”. Capital is still fully protected, however, given the 20 per cent discount in holdings, interest coupons are higher. In another option, holders receive discount bonds maturing in 17 years, with 40 per cent capital protection.

There is a high probability that, given that the exchange programme is voluntary, it would not create a credit default event, and hence will not trigger credit default swaps. Greece would need to receive at least 90 per cent acceptance from outstanding bondholders to proceed with this plan.

Germany, though, seems to be preparing itself for a Greek default. Amid Germany’s threats over the past weeks that Greece will not receive further funds unless it meets fiscal targets, Chancellor Angela Merkel’s government is debating how to shore up German banks should Greece not meet the conditions set in the bailout package and not receive further financial aid.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Some of the opinions expressed here above are of a forward looking nature and should not be interpreted as investment advice, nor should it be considered as an offer to sell or buy or subscribe to any investment vehicles or strategies that might have been mentioned in the article. The company and/or the author may hold positions in any securities that might have been mentioned in this report. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business. Should you wish to discuss this article in further detail, feel free to contact the author on 2342 6116.

Mr Micallef is an executive director at Curmi and Partners Ltd.